If you already or plan to make backdoor Roth IRA contributions, don't make this critical mistake
I have seen clients make a number of mistakes when it comes to the Backdoor Roth IRA strategy, and one of the most frequent is not being aware of the pro-rata rule and how it can cost them time and money.
When you make a backdoor Roth IRA contribution, if that money came directly from a non-deductible traditional IRA and that is your only non-Roth IRA, you won't owe taxes. But what if you also had $60,000 lying around in a rollover IRA that came from an old 401(k) or 403(b)? That money has never been taxed. This is where the pro-rata rule comes into play. Essentially this rule forces you to treat ALL of your non-Roth IRA's as one single IRA. This includes a normal traditional IRA, rollover IRA, SEP IRA, and SIMPLE IRA. They then use the total balances in all of these IRA's under your name to determine how much taxes you owe on your backdoor Roth contribution. As I mentioned before, if the only traditional IRA in your name is the one you make AFTER TAX contributions into each year, you don't owe taxes when you transfer it to your Roth because that money has already been taxed. Let's look at an example below.
For the sake of this example, we are going to say that you decided to contribute $6000 as a non-deductible contribution to your traditional IRA with the intent of converting to a Roth. You also have the above-mentioned $60,000 rollover IRA. Using the pro-rata rule, the IRS is going to tell you that the percentage of after-tax dollars in your non-Roth IRAs is 10%. ($6,000/$60,000). That's the percentage of your backdoor Roth contribution you get to say is tax-free. That means 90% of that $6,000 conversion you will have to pay taxes on. This, even though you already paid taxes on all of it. Let's say your marginal tax bracket is 22%, having the extra $60,000 rollover IRA could cost you $1188 in tax taxes for that year.
This is one of many reasons why high-income professionals must proceed with caution when an advisor is pitching them on rolling over their 403(b) or 401(k). They most likely don't bother to find out if you are doing backdoor Roth contributions and are more focused on gathering your assets so they can collect their AUM fees. If you find out after the fact that you have made this mistake, it's not the end of the world, but you should take steps either on your own or with a tax professional to correct it as soon as possible.